The deep mistrust that exists between Israel and the Palestinians will only be exacerbated by the announcement this week of 900 new homes in occupied territory, according to Britain’s ambassador in Tel Aviv.

Tom Phillips, in Britain this week, said: “I don’t know why the Israelis are doing this. There’s clearly a negotiation with the US over the nature of more building, a moratorium on settlements which it is hoped will be enough to get peace talks going again.

“It’s conceivable that the Israeli government wants to send a message to its right-wing at this time. If that is what’s being done it’s very unhelpful. From the Palestinians’ point of view, this is predetermining things still to be negotiated.”

Mr Phillips, who became ambassador in 2006, said: “There is enormous mistrust on both sides. I will always be optimistic, because both Israel and the Palestinians are great peoples, but I am worried about the situation.

“The British government backs a two-state solution but the opportunity for that is running out of time. Israel cannot be a high-volume, modern democratic society and an occupying power at the same time.

“There is also a question mark about whether either political system (Palestinian or Israeli) could take the toughest decisions about refugees and Jerusalem. I do understand what’s required and that the decisions involved go to the heart of individual narratives.

“However, I still think compromise is necessary. I really understand how much we are asking of Israel, to return east Jerusalem. We’re talking about their biblical kingdom and Israel has a right to know that if it is going to renounce this, it will get the security the state deserves. It is the decision that preserves the life of the Jewish people in Israel.

“If you look at the Palestinian story and the depth of their sense of victimhood — ‘we lost our homes, we have a right of return’ — they must compromise as well. Each side must compromise on an issue that touches its identity. That is going to require great leadership on both sides. I have to believe there is the leadership to do that,” said the ambassador.

He noted: “Mr Netanyahu says he is serious about the peace process and will carry it forward. Mr Abbas has long been committed to a two-state solution which is why people believe it would helpful if he stayed in office.

“The thing on the ground that is complicating matters is the settlement issue. When I came back in 2006” — he served as Britain’s consul general and deputy head of mission in 1990-1993— “I went around the West Bank. My initial feeling was that this was incredible, there was so much building.

“Now, depending on how these negotiations go and where the line ends up being drawn, plus or minus 1967, it’s clear that a large number of people will have to move. This is going to be extremely difficult for any Israeli government.”

While in the UK Mr Phillips has met Labour and Conservative Friends of Israel, spoken to Oxford students and met communal organisations working in Israel, where he has involved himself in numerous projects. “There are some fantastic projects and the contribution of British Jewish organisations is immense.”

Next week he will be a guest at the formation in Jerusalem of a new European Friends of Israel by the Zionist Federation.